Sunday, May 11, 2014

Supply-sider Alan Reynolds wrote a critique of nominal GDP targeting recently. David Beckworth responded. Lars Christensen also wrote a post that didn't mention the Reynold's piece, but in some ways was also a response.

Reynolds begins by arguing that nominal GDP growth is simply the sum of real GDP growth and inflation. He goes on to claim that if the Fed were to target nominal GDP, then if real GDP growth is high, then the Fed would be required to cause deflation and if real GDP growth is low, it would have to then respond by causing inflation.

Beckworth responded by pointing out that nominal GDP is calculated first, and then a price index is calculated. And then finally, real GDP is calculated by dividing nominal GDP by the price index. (In truth, several price indices are calculated for different types of nominal output--like consumer goods and services or capital goods. And then nominal consumption is divided by the consumer expenditure price index and investment by the investment index. The real amounts of the parts are added together. The implicit GDP deflator is actually calculated by dividing nominal GDP by real GDP. However, I am not sure to what degree that complication matters.)

We can imagine a world where the real economy is determined first. Perhaps a Walrasian auctioneer determines all the relative prices and quantities appropriate to general equilibrium. And then, the Fed sets the quantity of money, and the Walrasian auctioneer determines the money price level necessary to equate the demand to hold money to the quantity of money. And finally, everyone uses the already determined relative prices and the price level to determine money prices. First real output is determined and then the price level is determined.

The real world is nothing like that. The production of various goods and services, and so, real output is simultaneously determined with the money prices of those same goods and services, and so the price level.

Of course, I am using a microeconomic model to frame this vision. The demand curve for some good shifts to the left, and both the equilibrium price and quantity decrease.

However, the simple supply and demand model is literally based upon perfect competition. Instead, my true framing is monopolistic competition. The demand for some firm's product shifts to the left, and that reduces marginal revenue. Given marginal cost, this makes it profitable for the firm to cut production and prices. There is no first production and then prices to it. The firm jointly determines the price and quantity to maximize profit.

Some markets might come closer to a production first and then prices later approach. For example, the farmer plants seed. Months later, after weather happens, there is a harvest. Quantity is determined. And then, many agricultural products are sold on auction-type markets. Price is determined.

And even for a more typical market, production and prices necessarily depend on anticipated demand. If demand is less than anticipated, then excess inventory may well be sold at lower prices.

However, nominal GDP level targeting is all about reversing these sorts of decreases in demand. And so, given these simple models, such a reversal would result in inflation, but also increases in real output. If the demand curve shifts left now, and then later shifts right to its original position, then the equilibrium price first falls and then rises. The equilibrium quantity first falls and then rises. The same is true of the profit maximizing price and quantity combination for a firm in monopolistic competition. It falls with the decrease in demand and then rises again when demand recovers.

To the degree prices are sticky, then this fluctuation in price is dampened. This would be both the deflationary effect of the reduced demand and the "inflationary" recovery of price as well. For simple supply and demand, it is as if the short run supply curve is highly elastic.

Of course, there is a sense in which this entire analysis is a massive fallacy of composition. Nominal GDP falls, and so the demands for just about every good or service falls. And this analysis treats each and every good in isolation. When the demand for other goods fall, this increases the supply of a good, because opportunity cost for producing it is lower. And so, the decrease in nominal GDP implies a shift of demand to the left for all goods, but then also a shift in the supply of all goods to the right. The equilibrium price of all goods would fall, but their quantities would remain the same.

There is a sense in which this is what "should" happen. And in a world where all markets clear perfectly, I believe that this is what would happen. In such a world, real output and relative prices would be independent of aggregate demand, or more fundamentally, imbalances between the quantity of money and the demand to hold it.

But that is not the way the world works. Firms do respond to shifts in aggregate demand, that is, to shortages or surpluses of money, as they would if the demand for their particular product had changed. And so, reversing shifts in aggregate demand result in a reversal of undesirable shifts in real output and employment. And further, treating the inflation due to a recovery from deflation as if were somehow a "cost" is a mistake. Prices are recovering to where they belong.

Beckworth and Christensen, focuses more on shifts in aggregate supply. Given Reynold's reputation as a supply-sider, that makes sense. If you assume that prices are sufficiently flexible so that shifts in aggregate demand have little or no impact on real output, then what is left other than shifts in potential output?

Suppose various anti-business programs by the Obama administration have reduced potential output. Does that mean that real GDP falls, so the Fed would have to engineer an increase in inflation for nominal GDP to rise back to target? Is the extra inflation adding insult to injury?

Again, think about the micro implications. Suppose the government mandates benefits for workers in some industry. This raises costs. Using simple supply and demand analysis, the supply curve shifts left. The result is a simultaneous decrease in the equilibrium quantity and increase in the equilibrium price. If this occurs in all industries at once, then real GDP decreases and the price level increase simultaneously.

Considering monopolistic competition, the mandated benefit shifts the marginal cost curve for a firm to the left. The profit maximizing quantity is lower and the profit maximizing price is higher. If this happens to many firms at the same time, the result in reduced real output and a higher price level. There is no need to generate inflation to push nominal GDP back up to target.

Of course, again, this micro analysis is ignoring what is happening to all of the other markets. If all markets suffer added costs due to the mandated benefits, and they all produce less, so real output and income fall in aggregate. Lower income should reduce demand. Further, when the rest of the firms produce less, that reduces the opportunity cost for any one firm. These lower opportunity costs are signaled by reduced wages and other resource prices. Only to the degree lower real wages and other resource prices result in reduced offers for sale, does output fall in the aggregate.

If we imagine that all of price adjustments occur instantly, then we can imagine market clearing at an unchanged price level. Firms have higher costs because of the mandated benefits. They have lower costs due to paying lower wages and other factor prices. The reduced incomes for workers and other resource owners results in lower demand to match the lower supply in each market. But how realistic is that?

Quite the contrary, the most likely short run effect of increases in costs due to mandated benefits would be higher prices and reduced output. For the Fed to prevent this from causing inflation, it would have to reduced spending on output. This would force output and employment down even further, and if the Fed remained committed to this policy, eventually, wages and other factor incomes would fall to a lower growth path, allowing a very gradual recovery of output without any increase in inflation.

Christensen argues that if a central bank responds to adverse aggregate supply shocks by "tighter money," then we will see slower growth in real output due to the supply shock and then slower nominal GDP growth due to the central bank;s response. It will appear that slow real output growth "causes" slow nominal GDP growth. He points out that this is due to a regime that targets inflation.

I would add that if people expect the central bank to restrict nominal GDP growth to combat supply side inflation, then the expectation of slower growth in nominal GDP in the future will immediately depress nominal GDP. The inflationary effect of the adverse supply shock will be dampened. And further, the expectation of the future slowdown in spending will exacerbate the reduction in real output immediately.

With "flexible" inflation targeting, where we never know what the central bank is really going to do, then the possibility that they will suppress the inflation from the supply shock will dampen the inflation and exacerbate the reduction in output immediately. And then, when it turns out that they will in fact seek to dampen the inflation, so that there is no possibility that they will flexibly allow inflation to spike, then the more direct effects of the monetary tightening will be felt on both inflation and real output. More positively, if they do prove themselves willing to allow higher inflation, there should be some recovery of output as well as more inflation.